While multiple factors contributed to the steep selloff, the supply/demand imbalance in the global crude oil market and OPEC’s decision coming out of its November 2014 meeting, not to act as the marginal global swing producer was of particular significance. From the end of 2014 and through early 2016, energy equity markets experienced the steepest price correction since the 2008 financial crisis, and the energy high yield bond market effectively shut down, in what we define as the Energy Crisis.
In response, domestic upstream companies substantially reduced capital expenditures. As commodity prices declined throughout the course of 2015 and early 2016 and hedges rolled off, solvency, leverage, and liquidity concerns about upstream producers moved front and center. As a result of the pressure on the upstream sector, counterparty and volumetric risk consequently increased for midstream and services companies further down the energy value chain. This negative feedback loop led to significant strain across the energy complex and closed capital markets access to most public and private energy companies.
Management teams were then forced to shift to a more defensive game plan, prioritizing liquidity, lower leverage and balance sheet stability over short-term equity value creation. Multiple companies reduced dividend payouts and capital expenditures in order to internally fund growth projects and mitigate capital markets risk. As capital expenditure reductions continued, rig count and production decreases contributed to the first signs of commodity supply / demand rebalancing in 2016. Our impression is that while the overall energy sector remained stressed, commodity prices began to stabilize and capital markets subsequently re-opened for companies with higher quality assets.2
Many public upstream companies took advantage of this opportunity and stabilized their balance sheets by issuing common equity. In aggregate, approximately 47 secondary equity issuances were completed in the upstream sector alone, with $22B raised in 1H 2016. While equity dilution was significant (approximately 15% on average), investors supported these deleveraging activities and the average post offering price performance was +26% in H1 2016. These upstream transactions significantly benefitted the midstream sector as counterparty credit risk was reduced through the strengthening of producer balance sheets. We observed that debt capital markets activity also increased in Q2 2016, with particular focus on the investment-grade market, as midstream companies more actively issued debt to term out maturities and fund capital expenditure backlogs.
One of the important outcomes of the Energy Crisis was the material impact that it had on management behavior which we believe will lead to a sector that will be better positioned in future years.
In the Upstream sector, institutional investors encouraged companies to abandon strategies that emphasized production growth, elevated capital spending and capital markets dependency in favor of capital discipline, self-sufficiency, return on invested capital, free cash flow and return of capital versus dividends and buybacks. Management compensation programs have also been restructured to create better alignment with shareholders.
In the same vein, many midstream companies have focused on better corporate governance, right-sizing balance sheets and optimizing payout ratios. More specifically, institutional investors have used their influence to advocate for:
(i) Corporate structure simplification (GP / LP mergers) and increased alignment;
(ii) Distribution payout sustainability and higher coverage ratios; and
(iii) Increasing returns on capital deployed (versus distribution growth)
That said, companies still need to generate long-term growth and the above changes in investor preferences and management behavior have created an environment where companies are seeking to be less dependent on the public capital markets. This change in focus has required companies to focus on developing new sources of capital to fund their growth initiatives (for example via asset level joint ventures or structured financing solutions). As a result, investors with flexible investment mandates and long-term capital now have a broader opportunity set and can more effectively partner with companies to help them grow in this new post-Energy crisis environment.
In short, we believe the last four years changed the energy sector for the better. From the initial price declines in 2014 and 2015 and the capital markets shutdown of late 2015, many North American energy companies have evolved to having a business model that will be better positioned to withstand a wide range of macro and commodity price environments. Long term, we believe these changes have left the North American energy sector on a stronger footing and better positioned in the years ahead.
Footnote 1: Bloomberg, Generic 1st ‘CL’ Future (Spot Oil Price), Generic 1st ‘NG’ Future (Spot Natural Gas Price) from June 30, 2014 to January 31, 2015.
Footnote 2: Macquarie, "Investing Incentives and Governance", May 16, 2018
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